Getting
Out of the Credit Mess

The last thing we need is policy that encourages
or incurs more debt.

The federal government has announced a series of actions in the
past few weeks ostensibly designed to make consumer credit more
available and invigorate the economy. Obviously, the country is in
recession and the recession is likely to get deeper. But will
these actions reduce the depth and duration of the recession? Or,
in the long run, will they make matters even worse?

Chad Crowe

Last month the Federal Reserve and the Treasury announced that
the government would buy $500 billion in mortgages guaranteed by
Fannie Mae and Freddie Mac. They also announced they would lend
$200 billion against securities backed by car loans, student
loans, credit-card debt, and small business loans. The purpose of
both moves is to create lending capacity across key elements of
the consumer sector.

Most recently, the government announced that it would subsidize
new home mortgages by one percentage point, effectively lowering
monthly payments on a 30-year loan by about 10%. The stated reason
was to help the housing market, which is crucial to an economic
recovery.

With each announcement, the Fed and Treasury were careful to
point out they might take additional action in support of these
sectors and others as well. And it is a virtual certainty the
government will cobble together some program to reduce
foreclosures to keep people in their homes. I'm sure that, as
other industries or sectors come under pressure, there will be new
programs to help. The automobile industry will not be the last to
come to Washington.

To begin to understand today's problem, we have to have a sense
of how we got there. Between 1994 and second quarter 2008, the
U.S, housing stock more than doubled in value from $7.6 trillion
to $19.4 trillion. Almost three quarters of that increase was due
to a speculative bubble, the root cause of which was government
policies designed to increase home ownership, largely among people
who would be considered nonprime borrowers -- i.e., people without
sufficient documented income or employment history and little or
no savings or credit history.

The intellectual start of this mess was in a flawed Boston
Federal Reserve study published in 1992 that purported to show
that minorities were treated less well than whites. That study led
to increased political pressure on banks to modify their standards
with increased emphasis through the Community Reinvestment Act,
and aided by U.S. Department of Housing and Urban Development
regulations in the Clinton administration that required parity of
outcomes in the lending process.

The effect of all of this meddling was compounded by the lax or
incompetent supervision of Fannie Mae and Freddie Mac. All in all,
the government got into the business of encouraging and then
forcing lending institutions to make mortgage loans to people who
could not pay them back. What we ended up with is a failure of
government, which we have erroneously termed a failure of
capitalism.

The standards applied to these subprime loans began to be
applied to what heretofore had been prime borrowers who also
increasingly became overextended. But, as housing prices
increased, owners cashed out their equity and bought cars,
appliances and other items, including using the freed-up equity to
pay for everyday living purchases. Over the past decade alone,
U.S. households have taken on some $8 trillion in debt, bringing
the nation's current consumer debt load to $14 trillion.

This cynical and unsustainable cycle was abetted by mortgage
originators who had little interest in making sure loans were good
quality, investment banks that securitized and packaged these
loans, rating agencies who forgot fundamental laws of gravity, and
purchasers who bought securities they could not possibly
understand. This was fueled by borrowers who committed fraud and
bought houses, or speculated in them, when there was no realistic
chance they could afford them.

All of this led to a huge overleveraging in the consumer
market. The increase in debt burden fueled much of the nation's
economic growth over recent decades, aided somewhat by increases
in productivity and underpinned by easy money from the Federal
Reserve. Since consumers represent about 70% of the nation's GNP,
and since leverage cannot increase forever, we were bound to see
the bubble burst and eventually enter a substantial recession.

So, are the current credit easing actions likely to be helpful
or not? In my judgment, measures to create liquidity are likely to
be helpful. Financial institutions that lend money to
credit-worthy people for reasonable purposes have experienced a
substantial reduction in available funding from which they can
make loans. Hence the programs to support the securitization
markets are sensible because money used for this purpose will be
lent and used for purchases. Programs that deliver a short-term
reduction in mortgage rates will, at the margin, help absorb some
of the available housing stock, reducing the time it will take for
housing to reach market-clearing levels.

However, measures intended to reduce foreclosures, per se, are
likely to be ineffective at best and morally flawed at worst. When
analysts say that people are being foreclosed because house values
have declined they are missing the point. A large number of
foreclosures are taking place because people can no longer
refinance and take value out. They could not afford the houses to
begin with and greed or stupidity -- not a falling real-estate
market -- have caused their problems. On the other hand, measures
to subsidize homeowners facing foreclosures because they have lost
their jobs can be helpful.

In the longer term, our nation must delever -- either by
reducing the amounts of borrowing or by increasing consumer
earning power through economic growth. Relying on growth alone
implies a growth rate higher than we have ever experienced in our
nation's history. Nonetheless, our public policy must encourage
economic growth by lowering tax rates for corporations and
individuals while at the same time avoiding what would be growth
killers, including "card check" legislation and trade
restrictions. Public policy should support higher savings rates,
and avoid encouraging increased consumer spending funded by
further debt, which may be helpful in the short term but
catastrophic in the longer term.

It is not only consumers that must delever. Governments must as
well. State and local governments across the nation have incurred
direct and indirect debt or obligations in the tens of trillions
of dollars -- obligations that cannot be met under any set of
reasonable circumstances without an explosion in growth and tax
revenues. In fact, we continue to incur debt for politically
palatable ideas, like rebate checks, which have very little
stimulative power but increase the depth of the hole we're in.

To solve this problem for ourselves and future generations, we
must get back to our historic reliance on personal responsibility
and market forces, and get government out of economic management.
It doesn't do a good job, as the current economic mess amply
proves.